1. DAC 511 CORPORATE FINANCIAL REPORTING & ANALYSIS
GROUP 7 PRESENTATION
Prospective Analysis

2. GROUP MEMBERS No. Name Registration Number MERCY CHELANGAT1
MERCY CHELANGAT
D63/79059/2012 2
KOSGEI JUSTINE
D63/61383/2013 3
DAVID CHIKEKA
D63/73044/2012 4
ABDIRIZAK MOALIM
D63/60121/2013 5
NYANGALA ALLAN H.
D63/67803/2011 6
FRANK KILONZO M
D63/80470/2012 7
RICHARD NOAH
D63/60864/2013 8
ESBON WAMATHU W.
D63/61264/2013 9
DENNIS KIMANI
D63/60534/2013 10
VERA NYABOKE
D63/61416/2013

3. Prospective Analysis
Prospective analysis is the forecasting of the future financial information.
Two commonly used techniques for prospective analysis are:
Financial Statement forecasting
Valuation
Prospective analysis is central to security valuation where both free cash flow and residual income models require estimates of future financial statements.

4. Continue… Two broad stages of financial prospective analysis
What are prospective financial statements?
Prospective financial statements encompass:
Financial forecasts and
Financial projections
Two broad stages of financial prospective analysis
Long term forecasting : This involves the analysis of past data and forecasting of financial statements.
Implementation :- This is the use of the forecasts to value common stock or to accomplish any other objective for which the forecast was carried out.

5. Importance of prospective anlaysis
Security valuation:- Residual income model requires estimates of future financial statements
Management and assessment:- To examine viability of companies’ strategic plans.
Assessment of solvency:- Ability to meet company’s debt obligations
Prediction of future performance

6. Compilation of prospective financial statement
Procedure:
Inquire of the responsible party as to the underlying assumptions developed.
Compile or obtain a list of the underlying assumptions and consider the possibility of obvious omissions or inconsistencies.
Verify the mathematical accuracy of the assumptions
Read the prospective financial statements in order to identify departures from IAS 1 presentation guidelines
Obtain a client representation letter in order to confirm that the responsible party acknowledges its responsibility for the prospective statements

7. Steps in examining prospective financial statements
Step1:- examine inherent and control risk
Step2:- consider the sufficiency of internal and external sources of information supporting the underlying assumptions
step3:- Determine the consistency of the assumptions
Step4:- Determine the reliability and consistency of the historical financial information used
Step5:- Evaluate the preparation and presentation of the prospective financial statements
Step6:- Obtain a client representation letter to confirm that the responsible party acknowledges its responsibility for the presentation of the prospective financial statements and the underlying assumptions.

8. Projecting income statement
Projecting financial statements must begin with projecting the Income Statement
and projecting an Income Statement begins by estimating sales.
The sales estimate can be tested for plausibility in four different contexts :
Past sales trends
Market share implied by the sales estimate
Its relation to planned marketing efforts
Production capacity

9. Projecting income statement
Sales forecasts are a function of:
1) Historical trends
2) Expected level of macroeconomic activity
3) The competitive landscape
4) New versus old store mix (strategic initiatives)

10. Projecting cost of goods sold
Cost of Goods Sold (CoGS) is all costs which can be directly linked to sales.
Always projected as percentage of sales.
the percentage CoGS assumption can be affected by a variety of factors, both external and internal to the company.
external factor which increases costs, such as rising raw material prices, will increase the CoGS percentage, unless these costs increases plus margin can be passed on to customers
production efficiencies may decrease this percentage through lowering costs.

11. Projecting operating expenses
Operating expenses are those expenses which are not directly linked to sales.
Are projected on item by item basis
Projecting Depreciation and Interest expenses
Projecting Depreciation and Interest expense requires a look ahead to the projected balance sheet
Past interest expense will be analyzed as a percentage of past debt balances, and the trend extended into the future.

12. Steps in projecting the income statement
Project sales
Project cost of goods sold and gross profit margins using historical averages as a percent of sales
Project operating expenses using historical averages as a percent of sales
Project depreciation expense as an historical average percentage of beginning-of-year depreciable assets
Project interest expense as a percent of beginning-of-year interest-bearing debt using existing rates if fixed and projected rates if variable
Project tax expense as an average of historical tax expense to pre-tax income

13. EXAMPLE. Target Corporation statement of income
Figures in Millions
2005
2004
2003
Sales
46,839
42,025
37,410
Cost of goods sold
31,445
28,389
25,498
Gross profit
15,394
13,636
8,134
Selling, general and administrative expense.
10,534
9,379
Depreciation and amortization expense
1,259
1,098
967
Interest expense
570
556
584
Income before tax
3,031
2,603
2,227
Income tax expense
1,146
984
851
Income (loss) from extraordinary items and discounted operations
1,313
190
247
Net income
3,198
1,809
1,623
Outstanding shares
891
912
910
Selected rations in percent
Sales growth
11.455%
12.336%
Gross profit margin
32.866
32.447
Selling, general and administrative expense/Sales
22.49
22.318
Depreciation expense/Gross prior-year PP&E
6.333
5.245
Interest expense/prior-year long-term debt
5.173
4.982
Income tax expense/pretax income
37.809
37.803

14. Target Projected Income Statement computation.
1- Sales: $52,204 = $46,839 x
2- Gross profit: $17,157 = $52,204 x %
3- Cost of goods sold: $35,047 = $52,204 - $17,157
4- Selling, general, and administrative: $11,741 = $52,204 x 22.49%
5- Selling, general, and administrative: $11,741 = $52,204 x 22.49%
$1,410 =$22,272 (beginning-period PP&E gross) x 6.333%
6- Interest: $493 = $9,538 (beginning-period interest-bearing debt) x
5.173%
7- Income before tax: $3,513 = $17,157 - $11,741 - $1,410 - $493
8- Tax expense: $1,328 = $3,513 x %
9- Extraordinary and discontinued items: none
10- Net income: $2,185 = $3,513 - $1,328

15. ABC Projected Income Statement
Income statement in millions
Forecasting steps
2006 Estimates
Total revenues
$52,204
Cost of goods sold
35,047
Gross profit
17,157
Selling, general, and administrative expense
11,741
Depreciation and amortization expense
1,410
Interest expense
493
Income before tax
3,513
Income tax expense
1,328
Income (loss) from extraordinary items and discontinued operations
Net income
$ 2,185
Outstanding shares
891
Forecasting Assumptions (in percent)
Sales growth
11.455%
Gross profit margin
32.866

16. Projected balance sheet
Steps:
Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios as described below.
Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report.
Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios as described below
Obtain current maturities of long-term debt from the long-term debt footnote.
Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends.

17. ABC CORPORATION BALANCESHEET

18. Projection process

19. ABC CORPORATION BALANCESHEET

20. SENSITIVITY ANALYSIS
Vary projection assumptions to find those with the greatest effect on projected profits and cash flows
Examine the influential variables closely
Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible outcomes

21. Residual Income Valuation Model
The residual income valuation model defines equity value at time t as the sum of current book value and the present value of all future expected residual income:
where BVt is book value at the end of period t, RIt + n is residual income in period t + n, and k is cost of capital (see Chapter 1). Residual income at time t is defined as comprehensive net income minus a charge on beginning book value, that is, RIt = NIt - (k x BVt - 1).

22. Application of Prospective Analysis in the Residual Income Valuation Model
In its simplest form, we can perform a valuation by projecting the following parameters:
-Sales growth.
-Net profit margin (Net income/Sales).
-Net working capital turnover (Sales/Net WC).
-Fixed-asset turnover (Sales/Fixed assets).
-Financial leverage (Operating assets/Equity).
-Cost of equity capital

23. Advantages of Residual income model
1. Residual income models make use of data readily available from a firm's financial statements and can be used well with firms who do not pay dividends or do not generate positive free cash flow. 2. Residual income models look at the economic profitability of a firm rather than just its accounting profitability.

24. Drawback of using residual Income model
The biggest drawback of the residual income method is the fact that it relies so heavily on forward looking estimates of a firm's financial statements, leaving forecasts vulnerable to psychological biases or historic misrepresentation of a firms financial statements

25. Continue….
Therefore, the model is useful when;
A company does not pay dividends or dividends are not predictable
FCF is negative over a comfortable forecast horizon
There is great uncertainty in estimating terminal values
Not useful when;
1. There are significant departures from clean surplus accounting. E.g
Gains on marketable securities are reflected in stockholder’s equity as “comprehensive income” rather than as income on the income statement
Wide use of employee stock options
Foreign currency translations
2. Determinants of residual income (e.g., book value and ROE) are not predictable

26. Trends in Value Drivers
The Residual Income valuation model defines residual income as:
RIt = NIt – (k X BVt-1)
= (ROEt – k) X BVt-1
Where ROE = NI/BVt-1
- Stock price is only impacted so long as ROE ≠ k
- Shareholder value is created so long as ROE > k
- ROE is a value driver as are its components
- Net Profit Margin
- Asset Turnover
- Financial leverage
Two relevant observations:
- ROEs tend to revert to a long-run equilibrium.
- The reversion is incomplete.

27. Trends in Value Drivers
Reversion of ROE

28. Trends in Value Drivers
Reversion of Net Profit Margin

29. Trends in value drivers
Reversion of Total Asset Turnover

30. PROJECTED CASHFLOW STATEMENT
The statement of cash flows is another financial statement that provides financial information just as the balance sheet and the income statement
The purpose of this statement of cash flows is to provide information on the cash inflows and outflows of a certain business for a period
cash flow statement shows aspects of liquidity of a firm
The Cash Flow Projection shows the cash that is anticipated to be generated over a chosen period of time in the future.

31. Importance of Projections of cashflows
Uses of projection of cash flows are that it enables us to determine the
Credit worthiness of a company
Loan structuring
All in all the main purpose of preparing a cash flow projection is to determine shortages or excesses in cash from that necessary to operate the business

32. Steps in determining the projection of cash flow
1. Determine the total cash receipts which results from the cash sales, other income(credit accounts) and loans/other cash injections 2. Determine the total cash paid out which results from purchases, wages, Taxes (real estate, etc.), Supplies (office & operations),repair and maintenance, marketing, advertising, car delivery and travel, accounting and legal charges, rent, telephone and postal charges, utilities among others. 3. Determine noncash operations such as depreciation, gains or losses to assist us in changing from accrual basis to cash basis

33. Continue….
4. Using the indirect method we determine the net income from the income statement , where we deduct the expenses from the income then we adjust the non cash charges such as depreciation, gains or losses
5. After that we determine the net change in cash from operating, financing and investing activities where operating involve increase(decrease) in assets and liabilities, financing activities say increase(decrease) in long term debt, dividends among others and investing activities resulting from increase(decrease) in capital expenditures
6. Finally add (deduct) the net change in cash from the beginning balance to determine the projected ending balance.

34. THE END
THANK YOU